Prepayment Risk [CPR;PSA]

Prepayment risk is the risk that borrowers will repay loans earlier than scheduled, particularly relevant for mortgage-backed securities and other asset-backed securities. When interest rates fall, homeowners often refinance mortgages at lower rates, paying off existing loans early. For example, if rates drop from 6% to 4%, a surge in refinancing can cause MBS investors expecting 6% returns for 30 years to receive principal back early, forcing reinvestment at lower rates. This creates negative convexity – MBS prices don’t rise as much when rates fall due to prepayment risk. Prepayment models consider factors including rate incentive, seasoning (loan age), burnout (borrowers who haven’t refinanced despite opportunity), and seasonality. Prepayment speeds are measured by CPR (Constant Prepayment Rate) and PSA (Public Securities Association standard). Managing prepayment risk involves using models, investing in different MBS types (like CMOs with prepayment protection), and hedging strategies.